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IRS Letter Ruling 200710004 breaks new ground
in determining the character of a worthless stock deduction in a
consolidated group. Due to the lack of direct authorities on
point and the absence of clear statutory support for the
ruling’s favorable conclusions, taxpayers might consider seeking
their own letter rulings to benefit from the Service’s
interpretations in Letter Ruling 200710004, perhaps even
applying some of the principles to situations outside of a
consolidated group.

The
proposed transaction in the ruling is deceptively simple:
Holding was an insolvent U.S. corporation converted to a limited
liability company (LLC), resulting in its deemed liquidation.
This conversion caused Taxpayer, which owned at least 80% of
Holding’s voting power and value, to recognize a loss. The
interesting element was the way in which the gross-receipts test
of Sec. 165(g)(3)(B) was calculated.

Facts

Although the proposed transaction is
simple, certain background facts and some history are needed to
understand the conclusions reached in Letter Ruling 200710004.
Foreign Parent directly and indirectly owned 100% of Taxpayer, a
U.S. corporation and the parent of an affiliated group filing a
consolidated return. Taxpayer owned at least 80% of the voting
power and value of Holding, a U.S. corporation conducting
substantially all of its business operations through its
subsidiaries. At the time of the LLC conversion, Holding owned
100% of Sub1 and Sub2. Sub1 is a disregarded entity (DE) for
Federal tax purposes, conducting one line of business through
other DEs; Sub2 is a U.S. corporation conducting a second line
of business. Holding owed significant debt to related foreign
parties and a relatively small amount to Taxpayer.

At some point, Taxpayer determined
that it had overpaid for the Holding stock. After this
realization, Holding sold a substantial portion of its
operations and subsidiaries, and used the sale proceeds to pay
down some of the related-party debt. Holding’s sales
(collectively, the “Sec. 381 transactions”) fell into three
categories:

Sec. 338 transactions: Holding sold some first-tier
subsidiaries, and Holding and the buyer made joint elections
under Sec. 338(h)(10) to treat the transaction as a sale of
the subsidiaries’ assets, followed by a Sec. 332
liquidation.

Sec. 332 transactions: Some of Holding’s first-tier
subsidiaries sold their assets, then formally dissolved in a
Sec. 332 liquidation.

De facto liquidation transactions: Some of
Holding’s first-tier subsidiaries sold their assets, then
distributed the sale proceeds without formally liquidating
(e.g., due to potential contingent liabilities or
contractual obligations).

Taxpayer represented the following:
(1) Holding was insolvent and its stock was worthless; (2) the
Holding subsidiaries involved in the de facto liquidation
transactions liquidated pursuant to Sec. 332; and (3) Taxpayer
had no excess loss account in its Holding stock.

Analysis

The Service
ruled that Taxpayer could claim a worthless stock deduction
under Sec. 165(g) on the conversion of Holding into an LLC,
which is consistent with the position set forth in Rev. Rul.
2003-125 (see also CCA 200706011), but is not, in and of itself,
remarkable. It is sufficient to say that Taxpayer recognized a
loss, because no amount was considered to be received with
respect to the Holding common stock held by Taxpayer (i.e.,
there was found to be no “complete liquidation”); see Regs. Sec.
1.332-2(b); H.K. Porter Co., 87 TC 689 (1986); and
Spaulding Bakeries, Inc., 27 TC 684 (1957). The
primary issue was whether Taxpayer would recognize a capital or
an ordinary loss on its Holding stock, which depended on how
Holding’s gross receipts would be determined.

Gross
Receipts Are a Sec. 381(c) Attribute

For a worthless stock loss to be
ordinary (rather than capital) under Sec. 165(g)(3), more than
90% of the worthless corporation’s aggregate gross receipts for
all tax years must have been from sources other than royalties,
certain rents, dividends, certain interest, annuities and gains
from sales of stock and securities (i.e., passive gross
receipts). This gross-receipts test is applied without looking
through to any underlying gross receipts of lower-tier
corporations owned by the corporation being tested; see TAM
8939001.

Under Sec. 381, in a
Sec. 332 liquidation, the acquiring corporation succeeds to, and
takes into account up to, 22 of the liquidating corporation’s
tax attributes (as enumerated in Sec. 381(c)). These items
include net operating loss carryovers, earnings and profits
(E&P), capital loss carryovers, methods of accounting, etc.
Notably absent from this list are the transferor corporation’s
historical gross receipts, as defined in Sec. 165(g)(3)(B).

A common question in these fact
patterns is how a holding company, which itself may never have
produced its own gross receipts from operating a direct
business, should determine its aggregate gross receipts. Tax
practitioners have debated whether gross receipts (as well as
other nonenumerated possible tax attributes) should be viewed as
a tax attribute that moves to the acquiring corporation in a
Sec. 381 transaction; see, e.g., Rev. Rul. 75-223, in which the
Service applied this concept to permit partial-liquidation
treatment. If so, Holding might benefit from (or be burdened by,
if excessively passive) the gross-receipts history of each of
the companies that were part of the Sec. 381 transactions.

The IRS permitted/required Holding
to take into account the historical gross receipts from the
transferor corporations in each of the Sec. 381 transactions,
adjusted for certain intercompany distributions (discussed
below), to prevent duplication of gross receipts.

Excluded Intercompany Distributions

Letter Ruling 200710004 sets forth the
general consolidated rules governing intercompany transactions,
which are transactions between members of a consolidated group
and include intercompany dividends. Regs. Sec.
1.1502-13(c)(1)(i) provides that separate-entity attributes of a
seller’s intercompany items and a buyer’s corresponding items
are redetermined to the extent needed to produce the same effect
on consolidated taxable income (and consolidated tax liability),
as if the seller and buyer were divisions of a single
corporation and the intercompany transaction were a transaction
between these divisions.

With
no detailed analysis in the ruling, the Service used these
general rules to view the intercompany dividends received by
Holding (which are excluded from Holding’s gross income under
Regs. Sec. 1.1502-13(f)(2)(ii)) as Sec. 165(g)(3) gross receipts
(see similar principles applied to other traits in Rev. Ruls.
72-230 and 79-60). The IRS permitted/ required Holding to
include in its aggregate gross receipts all dividends received
from lower-tier subsidiary members of the consolidated group;
such dividends were treated as from passive sources only to the
extent attributable to the respective distributing member’s
gross receipts from passive sources. For this purpose, dividends
were attributed pro rata to the gross receipts giving rise to
the E&P from which the dividend was distributed. Despite the
statutory classification of dividends as passive receipts, some
or all of the intercompany dividends can be treated as active
receipts, to the extent attributable to active receipts of the
subsidiary.

As previously stated,
if a parent earns gross receipts in the form of dividends from a
subsidiary that later liquidates in a Sec. 381 transaction, the
subsidiary’s underlying gross receipts should not be
double-counted in the parent’s hands.

Complete
Liquidation and Worthless Stock

The final issue relates back to the
threshold matter of whether Taxpayer could recognize a loss on
its Holding stock. The ruling highlights a special rule
governing worthless stock in a consolidated group.

Regs. Sec. 1.1502-80(c) states that a
member’s stock is not treated as worthless for Sec. 165 purposes
before such stock is treated as being disposed of under the
principles of Regs. Sec. 1.1502-19(c)(1)(iii), which provides
that the holder of stock (P) is treated as disposing of a share
of its stock in another group member (S) at the time that the
stock is considered worthless. For this purpose, S’s stock is
deemed worthless when substantially all of its assets are
treated as disposed of, abandoned or destroyed for Federal
income tax purposes (e.g., under Sec. 165(a) or Regs. Sec.
1.1502-80(c)). S’s assets are not deemed disposed of or
abandoned to the extent that the disposition is in complete
liquidation of S.

As with the
qualification for Sec. 332 treatment previously discussed, the
IRS reasoned that a complete liquidation refers to one in which
at least a nominal distribution (i.e., greater than zero) was
made by the liquidating corporation and received by the
distributee corporation in its capacity as a shareholder. This
overt conclusion represents a helpful clarification of the
definition of “complete liquidation” in these consolidated
return rules. (Query whether this definition might also apply to
“complete liquidation” as used in Regs. Sec. 1.1502-13(j)(2)(B),
which relates to the definition of “successor persons.”)

Conclusion

Excluded intercompany
dividends were deemed to constitute Sec. 165 (g)(3) gross
receipts to the recipient in proportion (passive versus
non-passive) to the underlying E&P from which they were
paid (but do not duplicate such gross receipts if the
dividend-paying subsidiary later liquidates in a Sec. 381
transaction); and

A taxable dissolution of a
subsidiary does not constitute a complete liquidation for
purposes of Regs. Sec. 1.1502-19(c)(1)(iii)(A) and-80(c)
(and perhaps also, by inference, Regs. Sec.
1.1502-13(j)(2)(B)).

Of course, further consideration will
be required to determine the application of these principles
absent receipt of a letter ruling. Also, while not mentioned in
Letter Ruling 200710004, tax advisers should remember that a
loss (including a worthless stock loss) on the stock of a
consolidated group member is deductible only to the extent that
it successfully runs the gamut of the consolidated loss
disallowance rules found in Regs. Sec. 1.337(d)-2 (see safe
harbors in Notice 2004-58). Even then, taxpayers must attach the
Regs. Sec. 1.337(d)-2(c) statement or the entire loss will be
disallowed.

EditorNotes

Unless otherwise indicated,
contributors are members of or associated with KPMG LLP. The
views and opinions are those of the authors and do not
necessarily represent the views and opinions of KPMG LLP. The
information contained herein is general in nature and based on
authorities that are subject to change. Applicability to
specific situations is to be determined through consultation
with your tax adviser.

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